1.49 The Spreadsheet is a predictive tool that relies on estimates of future cash flows. Economic decision-making is, however, a present-day activity and therefore a method is needed to return estimated and uncertain future economic cash flows to present day value. This is achieved by discounted cash flow analysis.
1.50 Discounted cash flow analysis can be conducted in real or nominal terms. In either case, it is critical that the rate by which future cash flows are discounted is consistent with the price basis on which cash flows are stated. If, on the one hand, all current and future cash flows are stated in real terms (i.e. today's prices), then the discount rate used to return these cash flows to present-day values should be 3.5%, as required by the Green Book6. If, on the other hand, current and future cash flows are stated in nominal (i.e. money-of-the-day) terms (as is the case in the Spreadsheet), then the real discount rate should be adjusted by the GDP Deflator value. In the Spreadsheet this is fixed at 2.5%. Accordingly the nominal discount rate is shown in the Input sheet as a hard-wired variable of 6.09%.
1.51 Procuring Authorities use the Spreadsheet by inputting values in either nominal or real terms. Where cash flows are expressed in real terms, Procuring Authorities will need to ensure that all relevant Input and Default Values (including escalators) are stated on a consistent price basis.
6 The Green book includes a declining schedule of discount rates for periods over 30years. As noted in the PFI VfM Assessment Guidance November 2006, currently it is envisaged that the overall cap on contract lengths will be a maximum of 30 years with shorter contract lengths in some sectors reflecting the different service requirements in each sector - departments will need to demonstrate that projects in excess of 30 years can offer VfM.